In the classical model of a small open economy, the domestic interest rate (r) is equivalent to the world interest rate (r*), where the r* is exogenous for the small open economy. Which assumption(s) implies the exogeneity of the r*?
Question
In the classical model of a small open economy, the domestic interest rate (r) is equivalent to the world interest rate (r*), where the r* is exogenous for the small open economy. Which assumption(s) implies the exogeneity of the r*?
Solution
The exogeneity of the world interest rate (r*) in the classical model of a small open economy is based on the assumption that the economy is "small" compared to the rest of the world. This implies two key assumptions:
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The economy is a price taker in the international capital market: This means that the economy is too small to influence the world interest rate through its borrowing or lending decisions. The world interest rate is determined by larger global forces, such as the monetary policies of major economies and global supply and demand for capital.
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Perfect capital mobility: This means that there are no restrictions on the flow of capital into or out of the economy. Investors can freely move their capital to wherever they can get the best return. This ensures that the domestic interest rate quickly adjusts to equal the world interest rate, as any difference would be eliminated by investors moving their capital.
So, the exogeneity of the world interest rate in a small open economy model is implied by the assumptions of the economy being a price taker in the international capital market and perfect capital mobility.
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